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October 30, 2012

Bank regulators have been as busy as usual in 2012, but some of the more interesting regulatory and legal changes have come from non-bank regulators and the courts. And, the JOBS Act changes described below actually lifts the regulatory burden on banks a bit, a rare respite in an otherwise challenging regulatory environment.

“Going public” is easier. Banks that have less than $1 billion in gross revenue can qualify as an “emerging growth” company and take advantage of relaxed rules that allow them to “test the waters” and obtain a confidential prior review of an IPO filing by the SEC, provide reduced executive compensation disclosures and file without a SOX 404 attestation by the bank’s auditors.

The “crowdfunding” rule (expected in early 2013) will provide banks significant flexibility in raising $1 million per year from their community without IPO-type expenses and without adding new investors to their shareholder count.

Private offerings are easier. Rules affecting private offerings are being relaxed so that a bank will be able to use public solicitation and advertising to attract investors as long as the bank takes reasonable steps to ensure that those investors are accredited.

Going or staying private is easier because the shareholder count triggering “going public” was raised from 500 to 2,000. And, shareholders from a bank’s “crowdfunding” offerings and from employee compensation plans are now excluded from the shareholder count. These helpful changes to shareholder count rules mean that some banks can bring in new investors or even acquire another bank without triggering the obligation to “go public,” a significant cost and compliance barrier. Also, banks with a shareholder count under 1,200 can “go private” following a 90-day waiting period.

Basel III. There are several important issues for community banks in the August 2012 notices of proposed rulemaking by the OCC, Federal Reserve and FDIC related to the Basel III-driven revisions of those agencies’ capital rules:

The introduction of a “Common Equity Tier 1” risk-based capital requirement and an increase in the Tier 1 risk-based capital requirement.

Changes in risk-weighting of 1-4 family mortgage loans based on loan to value ratios and providing for increased risk-weighting for 1-4 family mortgage loans with certain features, including balloon payment structures.

Phase-out of trust preferred from Tier 1 capital even for institutions having less than $15 billion in assets.

Requiring a capital conservation buffer even for banking organizations that are not systemically significant.

Inclusion of unrealized gains and losses on securities in common equity Tier 1 capital.

Increased risk-weighting for certain commercial real estate loans.

Risk-weighting credit exposures more than 90 days past due or on nonaccrual at 150%.

Banks subject to “remittance transfer” regulation. The most significant new regulation affecting bank deposit-side operations are the CFPB’s complex new remittance transfer regulations added to Regulation E. The following types of transactions commonly handled by banks are covered:

consumer wire transfers to an international recipient (consumer or business),

international ACH transactions,

online bill payments to an international recipient, and

an addition of funds to certain prepaid cards used by a person in a foreign country.

These remittance transfer rules contain extremely detailed requirements for pre-payment disclosures, written receipts, error resolution rights, cancellation and refund rights. The CFPB included temporary measures that allow banks—in some situations–to use “estimates” instead of defined amounts and rates in their disclosures. However, calculating these “estimates” remains a challenge and concern to banks. The remittance rules take effect on February 7, 2013.

Heightened legal risks in online deposit account security. A recent harsh federal court decision in the Patco Construction Co. case (July 2012, First Circuit Court of Appeals in Boston)faulted a bank for not using features of its computer system that the court theorized could have been used to prevent account hijacking.The court also faulted the bank for taking a uniform approach to fraud prevention, i.e., not taking the customer’s particular circumstances into account. The case and the Federal Financial Institutions Examination Council guidance on internet banking suggest that bank directors require management to appropriately address all sides of the online account security issue, including implementing an appropriate system across the bank’s customer base, re-examining insurance coverage in light of account size, and integration of Bank Secrecy Act compliance with anti-fraud measures.

Bank D&O liability. The case law surrounding bank director and officer liability is constantly developing. As of July 2012, the FDIC had filed 31 professional liability lawsuits against 6% of failed banks in the latest wave of failures. In cases throughout 2012, courts have clarified the standard of liability for bank directors in certain jurisdictions, dismissing liability claims based upon allegations of ordinary negligence by the FDIC against directors. However, it is currently unclear whether this higher standard would also apply to suits brought against bank officers in those jurisdictions, and other jurisdictions may apply their relevant law differently. In addition, courts have allowed FDIC claims to proceed against bank directors and officers based on allegations that uncontrolled rapid growth and concentration in highly risky types of loans rose to the level of gross negligence. In short, the FDIC is working strenuously to expand the scope of D&O liability. Meanwhile, many D&O insurers are mitigating risk in their portfolios by developing new methods to exclude FDIC claims from coverage. Several lawsuits have been filed seeking to clarify the scope of D&O coverage in situations where the carrier has denied coverage for an FDIC claim. This dynamic strongly suggests that bank directors should closely examine their insurance policies to ensure that their understanding of the coverages and exclusions from coverage applicable to them are accurate and up to date, and that any action that may need to be taken to preserve coverage can be taken in time to be effective.

Bank Lending. Consumer lending, particularly mortgage lending and servicing, remains subject to a regulatory onslaught. It is interesting to compare the staid language of the regulation itself in the Federal Register compared to the lurid description of the same regulation that the CFPB posts on its blog. An example are the new mortgage servicing standards being implemented in 2013, which the CFPB’s blog promotes as “designed to put the service back in mortgage servicing” and to “benefit borrowers by eliminating surprises and run-arounds.”

Reorganization of California state banking regulators. Community banks in California should stay alert for structural changes in state chartering authorities similar to the reorganization slated for the California Department of Financial Institutions (the “DFI”). Under Governor Jerry Brown’s Reorganization Plan 2, the DFI will be merged with the Department of Corporations into (and become a mere division of) a newly created Department of Business Oversight. The DFI Commissioner will be demoted to a Deputy Commissioner. There is significant concern within the banking and legal community that this reorganization will significantly devalue the California state banking charter and the quality of banking oversight in California. Accordingly, there appears to be an effort underway to legislate some changes to the Reorganization Plan. Community banks are advised to monitor these developments.